Bet on Fannie and Freddie's fall proves winning one

By Jennifer Ablan and Kristina Cooke - Analysis

NEW YORK (Reuters) - The brutal drop in Fannie Mae and Freddie Mac's shares has left a select few with a huge windfall.

Doug Kass, Jim Rogers and Doug Noland are some of the most prominent fund managers who bet against the survival of the government-sponsored enterprises as publicly traded companies.

The sinking shares have also put a less-than-flattering spotlight on some of the most well-known money managers, including well-known deep-value investors David Dreman, Legg Mason's Bill Miller and Richard Pzena, who stuck with their holdings even as Fannie and Freddie shares plunged a jaw-dropping 90 percent this year.

This week, investors have turned increasingly fearful that the federal government will be forced to bail out the two companies, which own or guarantee about half of all U.S. mortgages, potentially wiping out the two firms' equity value. On Thursday, Fannie closed at $4.85, down from around $70 a year ago, and Freddie finished at $3.16, compared to about $65 a year ago.

The dramatic collapse of Fannie and Freddie's shares highlights which fund managers foresaw the extent of the domino effect that falling home prices set in motion.

"I think the longs are in denial," said Kass, who famously shorted "everything related to housing" in 2007. His short positions on Fannie and Freddie have helped boost his flagship Seabreeze Partners Short fund, which is posting returns of more than 24 percent, excluding fees, in the year to date.

"We don't think there is going to be much value there for shareholders when you have big government bailouts coming," added Doug Noland of the Prudent Bear Fund, who has been shorting stocks for nearly 20 years.

In a short sale, investors borrow shares and sell them, betting that the stock price will fall. The goal is to buy the shares back at a lower price, allowing the investor to return the shares to the broker while taking a profit on the spread between the original sale price and the cost of buying back the shares.

For institutional investors trading in hundreds of thousands or millions of shares, the short sale of Fannie or Freddie in the last year or two as the shares have fallen by as much as $70 could have resulted in huge profits.

Kass, Rogers and Noland, however, aren't talking about how much they've actually made.

Meanwhile, there are those who aren't throwing in the towel on Fannie and Freddie.

Dreman, who is considered a dean of "contrarian-value" investing by purchasing beaten-down stocks, said in an interview there is "enormous upside" if the government provides Fannie and Freddie time to work out some of their problems. Also, if losses stay in the companies' projected range, he says that will also bolster the stocks.

"The markets are really trading these on previous losses," said Dreman, the head of Dreman Value Management LLC, a New Jersey-based investment firm with more than $15 billion of assets under management.

Dreman, who held 10 million shares of Fannie and 12 million shares of Freddie as of June 30, concedes that "anybody who's bought the stock recently is not happy, even somewhat horrified with this collapse."

"Part of this collapse is just panic," he said.